I. IntroductionIf general acceptance by the economics profession were the criterion
for success or failure of a theory, the theory of the trade cycle attributed
to F. A. Hayek(1) would have to be declared
a failure. Many economists do not know what the theory is, and many are
sure that the theory is fundamentally wrong-headed. Personal experience
has taught me that these two categories are not mutually exclusive. Even
those who recognize the logical integrity of the theory may have doubts
about both its historical significance and its present-day relevance: The
Hayekian theory might explain some aspects of some nineteenth- and early
twentieth-century trade cycles, but it does not explain much, and it does
not explain anything about modern fluctuations in economic activity.
Yet, there remains a small
minority of economists who see virtue and relevance in the Hayekian theory
of the trade cycle. For this minority the theory enjoys a certain prominence
within a broader theoretical framework. Expositors of Austrian Economics
save the trade-cycle theory for their climactic chapter. Comparisons of
the Austrians with the Keynesians or Monetarists invariably hinge on differing
views about the nature and causes of cyclical fluctuations. And historical
applications of Austrian monetary theory focus attention on the Great Depression.
The status accorded the Hayekian theory of the trade cycle seems—especially
to those outside the Austrian tradition—to be out of proportion to the
significance of the phenomenon this theory is intended to explain.
A half century after Hayek
outlined its essential features, the theory has strong but narrow support.
What follows is an attempt to account for this limited success. Section
II provides a brief outline of the theory and suggests that, ironically,
the many virtues of the theory are collectively an obstacle to a broader
acceptance. Section III contrasts the Austrian view with the alternatives
of Keynesianism, Monetarism and New Classicism, paying special attention
to the notion of Rational Expectations. Section IV deals with the issue
of expectations in the context of Hayek's theory. Section V considers some
common objections to the Austrian view, and Section VI offers a summary
assessment.

II. The Theory and Its ElementsThe Austrian theory of the trade cycle draws heavily from Knut Wicksell's
work on the relationship between money and interest. Ludwig von Mises (1953,
pp. 357-66; also see 1966, pp. 538-86 and 1983, pp. 1-6) was the first
to combine Wicksell's monetary dynamics with Böhm-Bawerk's capital
theory so as to produce a distinctly "Austrian" trade-cycle theory. Hayek
(1967) formalized the theory and bolstered it with the insights of David
Ricardo and John Stuart Mill. In its essentials, the Hayekian theory shows
how a monetary disturbance can induce an intertemporal discoordination
of economic activities (the artificial boom), how the discoordination eventually
comes to be recognized (the bust), and what adjustments are made necessary
by the money-induced discoordination (the recovery).
In brief, the injection
of new money through credit markets suppresses the rate of interest causing
resources to be intertemporally misallocated. Capital goods appropriate
for a relatively lengthy, or time-consuming, structure of production are
created at the expense of capital goods that would be more compatible with
the existing, less time-consuming, structure. The credit-financed capital
restructuring entails a net increase in economic activity, which constitutes
the boom. But with the passage of time, the still-incomplete capital restructuring
is revealed to be inconsistent with actual resource availabilities. The
newly perceived scarcities are reflected in increased prices of uncommitted
resources and in a corresponding increase in the demand for credit. These
increased costs necessitate the liquidation or abandonment of misallocated
capital. Labor which was complementary to the abandoned capital becomes
unemployed. The bust is followed by a recovery in which market adjustments
in relative prices and wages allow for the eventual reabsorption of unemployed
capital and labor into the structure of production.
The Austrian theory of the
trade cycle draws from price theory, capital theory, and monetary theory.
Hayek's formulation, in effect, "puts it all together." It allows the insights
of the Austrian school, together with insights from other schools, to gel
into a cohesive account of cyclical fluctuations. And it "puts it all together"
in a theoretically satisfying and historically relevant way. Those who
appreciate each element in the Hayekian theory and see how all the elements
fit together will have a special appreciation for Hayek's achievement.
They will see the trade-cycle theory as a veritable show-case for the contributions
of the Austrian school.
There is a high degree of
complementarity among the several elements of the theory. Thus, those who
reject any one element or fail to appreciate its significance will fail
to appreciate the theory as a whole. More likely, they will be puzzled
by it. The following identification of individual elements of the theory
will help to establish the significance of each for the composite theory
as summarized above.

(1) Prices are signals.
While prices are determined by the interplay of the activities of all
market participants, they convey essential information to each market participant—about
the changing valuations made by consumers and about the relative scarcities
of alternative resources (Hayek, 1948b.) This particular insight—that the
price system is a communications network—is well recognized by the profession.
Less well recognized is the fact that price changes do not come clearly
marked "nominal" or "real."(2) The price
theorist can conceptually distinguish between a real price change and a
money-induced price change in a simple and unambiguous way. But the market
participant cannot. The market participant does not possess a "knowledge
of the real factors" that would allow him to sort out the nominal and the
real; he in fact depends upon nominal price changes to tell him what the
real factors are. Thus, price signals provide the basis for economic coordination;
price signals falsified by monetary manipulation create a basis for economic
discoordination.

(2) The interest rate facilitates intertemporal coordinationThe interest rate clears the market for loanable funds. It matches
saving with investment. These statements are acceptable summaries of the
function of the interest rate, but they severely understate its importance.
Changes in the interest rate—caused, for instance, by changes in savings
propensities—affect not only the total amount of investment but also the
pattern of investment. A lower interest rate encourages investing for the
more remote future. Under favorable circumstances, the interest rate allows
the preferred time pattern of consumption activity to be translated into
a corresponding time pattern of investment activity; it coordinates the
two kinds of activities intertemporally (Hayek, 1984).

(3) Money can masquerade as saving.When the monetary authority pads the supply of loanable funds with
newly created money, it drives a wedge between saving and investment. An
artificially low rate of interest induces investors to borrow more while
income-earners are saving less. And the falsified interest rate causes
the time pattern of investment to be inconsistent with the amount of real
saving and with the preferred pattern of consumption (Hayek, 1967, pp.
54-60; Also see O'Driscoll, 1977, pp. 70-82). Monetary manipulation creates
unfavorable conditions which give rise to intertemporal discoordination.
Credit expansion whets the appetite of producers causing them—collectively—to
bite off more than they can chew, to undertake more time-consuming production
projects than can be completed.

(4) Capital is characterized by intertemporal complementarity.Capital goods are heterogeneous in nature and are related to one another
by various degrees of substitutability and complementarity. Given the time
consuming nature of the investment process, the problem of investment—from
a societal point of view—is one of committing some resources to the early
stages of the processes while reserving enough resources for the later
stages. The capital goods associated with the early and the late stages,
or alternatively: higher-order capital goods and lower-order capital goods,
are intertemporal complements. Intertemporal discoordination triggered
by an artificially low interest rate manifests itself initially as overinvestment
in higher-order capital goods. But only the passage of time and the subsequent
scarcity of (complementary) lower-order capital goods will reveal this
intertemporal discoordination (Hayek, 1967, pp. 85-100; Also see O'Driscoll
and Rizzo, 1985, pp. 160-87 and Lachmann, 1978, 117-18 and passim).

(5) The Ricardo Effect.In its original form, the Ricardo effect pertained to the substitution
of machinery for labor in response to changes in the rate of interest.
Machinery represented the long-term factor of production, and labor the
short-term factor of production. In the context of Hayek's trade-cycle
theory, the substitution is between higher-order capital goods and lower-order
capital goods. During the early phase of the cycle, an artificially low
rate of interest favors investment in capital goods of higher order. The
subsequent scramble for the complementary lower-order capital goods causes
their prices to be bid up sharply. Increased demands in credit markets—called
"desperation borrowing" in the Monetarist literature—drives the interest
rate up.(3) The sharply increased interest
rate severely discourages further investment in higher-order capital goods
and encourages the liquidation of some partially completed production projects
(Hayek, 1948a and 1977).

(6) Mill's Fourth Fundamental Proposition.John Stuart Mill's cryptic aphorism, "Demand for commodities is not
demand for labor," warns us against the simplistic incorporation of derived
demands into macroeconomic theorizing. Some such notion of derived demand,
whereby the demand for final output and the demand for the factors of production
always move in the same direction, characterizes virtually all modern macroeconomic
theories. The recognition that the two demands can move in opposite directions
characterizes the Austrian formulation and constitutes one of the most
fundamental differences between the Austrian theory and its rivals.
In accordance with Mill's
Fourth, a decrease in the current level of consumption does not necessarily
mean a decrease in the demand for labor (and for other factors of production);
a decrease in the current level of consumption may mean instead an increase
in the level of saving, an increase in the level of future consumption,
and a corresponding shift of resource demand away from the production for
current-period consumption and toward the production for future-period
consumption (Hayek, 1941, pp. 433-39). There may even be a net increase
in the current demand for capital and labor.
Hayek and other Austrian
theorists have heeded Mill's Fourth by recognizing that in a given period
consumption spending and investment spending can—and, in conditions of
full employment, must—move in opposite directions. In fact, it is the shifting
of resources between consumption and investment activities—and between
the different stages of the production process—in response to changing
intertemporal consumption preferences that allows the economy to achieve
intertemporal coordination. And it is the similar shifting of resources
in response to monetary manipulations that constitutes intertemporal discoordination.

(7) Two kinds of knowledge.Monetary manipulation can fool market participants into behaving differently
than they would otherwise behave. This fooling, of course, would not be
possible if market participants had enough knowledge—knowledge about consumer
preferences, resource availabilities, and technology, about the plans of
other market participants, and about how all these plans will affect one
another as the market process unfolds. It is true but trivial that if market
participants were already in possession of all the information that the
price system conveys, then distortions of price signals could not cause
cyclical fluctuations—or any other kind of disequilibrium. Hayek's distinction
(1948b, pp. 79-80) between two kinds of knowledge allows us to take account
of what market participants can and cannot reasonably be expected to know.
The distinction is that between the knowledge of the particular circumstances
of time and place (i.e. normal market information coupled with various
degrees of entrepreneurial insights) and scientific knowledge (i.e. an
understanding of how the economic system works—knowledge of the structure
of the economy). Market participants can reasonably be expected to have
the first kind of knowledge, but not the second kind. Given their knowledge
of the particular circumstances of time and place, they can be induced
by market-determined prices to behave "as if" they understood the structure
of the economy. But they cannot be expected to correct for money-induced
price distortions on the basis of an actual understanding of the economy's
structure.

Each of these seven elements
contributes in an important way to a full understanding of the Hayekian
theory of the trade cycle. To reject any one element is to threaten the
logical consistency of the theory. But the acceptance of all seven elements
still leaves unanswered many questions about the relative merits of the
Hayekian theory in comparison with alternative theories, as well as questions
about the role of expectations and about the historical applicability and
significance of the theory.

III. Alternative ViewsChallenges to the Hayekian theory were based first on Keynesianism,
then Monetarism, and now on the New Classicism. Keynes (1936, pp. 320-29)
faulted his contemporaries (Hayek and Robertson) for believing that the
interest rate was too low during the boom. He was convinced that it was
too high. Keynes could not understand why they advocated nipping the boom
in the bud; he suggested instead that it was the bust whose bud should
be nipped. The logical connection between the boom and the bust was not
seen by Keynes because he failed to treat the rate of interest as a device
for facilitating intertemporal coordination. He believed, instead, that
the interest rate is a highly psychological, highly conventional, phenomenon
and is determined by the interplay between the supply and the demand for
money.
Monetarists recognize the
role of the interest rate in achieving intertemporal coordination, but
downplay the possibility that monetary manipulations distort the interest
rate. In formal theory, questions about interest-rate effects are skirted
by assuming that newly created money is introduced into the economy in
ways other than through credit markets, such as by means of a helicopter
drop (Friedman, 1969a, p. 4). In applied theory, the injection effects
of monetary expansion—whatever their actual form—are trivialized as "first-round
effects." Attention is directed instead to the long-run effects of money
creation on nominal incomes and the level of prices.
When attention is focused
specifically on the issue of monetary dynamics—the "transmission mechanism"
in the terminology of Monetarism (Friedman, 1976)—the analysis is typically
confined to the labor market. Lagging adjustments in the perception of
real wages allow for trading-off unemployment for inflation as suggested
by the Phillips curve. While squaring the existence of short-run negatively
sloped Phillips curves with a vertical long-run Phillips curve, the Monetarists
simply neglect the possibility of intertemporal discoordination within
market for capital goods.
The New Classicists accept
the Monetarists propositions about the long run and argue that the assumption
of "rational expectations" allow those propositions to apply to the short
run as well (Maddock and Carter, 1982. Also see Butos, 1985, and Lucas
1981). In effect, the New Classicists deny the significance of Hayek's
distinction between two kinds of knowledge. Market participants behave
"as if" they actually know the structure of the economy. They react to
monetary expansions in ways that compensate for price and interest-rate
distortions. So long as expectations about future price and interest-rate
movements are not systematically in error, there will be no intertemporal
discoordination—and no discoordination of any other kind that can be attributed
to the monetary expansion. In this view, a Hayekian trade cycle anticipated
is a Hayekian trade cycle avoided.
The rational-expectations
argument is nothing new to Austrian theory. In fact, Mises (1953, p. 419)
recognized the kernel of truth in this argument long before the appearance
of John Muth's classic article. He warned the advocates of inflationary
finance against ignoring Lincoln's dictum: You can't fool all the people
all the time. In the early 1940s Ludwig Lachmann (1977) called the Austrian
theory into question on the basis of what was, in effect, a rational-expectations
argument. The rise of the New Classicism in the last several years has
refocused attention on the role of expectations in trade-cycle theory.
Without doubt, the course of the trade cycle is influenced in a fundamental
way by the expectations of market participants. But the idea of rational
expectations is not quite the show stopper that the New Classicists believe
it to be. Again, the critical difference between New Classicism and Austrianism
lies in differing treatments of the knowledge problem.
It is peculiar for economists
to assume that market participants know, or behave "as if" they know, the
structure of the economy. After all, economists have had disagreements
among themselves for more than two-hundred years about how the economic
system works. Some believe that the economy works in the manner envisioned
by Keynes or by his many interpreters, some believe that the economy is
more accurately depicted by the Classical model, and some believe that
the economic relationships identified by the Austrians are essential to
the understanding of the economy's structure. There are important differences
even within each of these three theoretical frameworks, and there exist
still other, more radical, alternatives such as Marxism and modern Institutionalism.
It would be an amazing feat
for market participants either individually or collectively to single out
not only the correct theoretical framework but also the parametric values
that are currently applicable. And if they actually performed this feat
(or behaved "as if" they had performed it), the question of just how they
did it would be the most challenging question the economics profession
has yet faced.
Visions of the economy that
are based on the assumption of rational expectations can be put into perspective
by the use of a simple Venn diagram—so simple that it is not necessary
to actually draw it. Let one circle represent "what economists know"; let
a second circle represent "what market participants know." The two circles
overlap but do not coincide. The area common to both circles represents
the common knowledge that makes a science of economics possible. It represents,
for instance, the knowledge that under normal market conditions a surplus
of some particular commodity means the price is too high and that a shortage
means the price is too low. The area unique to market participants includes
entrepreneurial insights and what Hayek (1948b, p. 81) called knowledge
of the particular circumstances of time and place. The area unique to economists
includes knowledge of the structure of the economy.(4) This Venn diagram allows
for the identification of two fundamental ways in which economists can
go awry. (1) They can deny the existence of knowledge unique to market
participants. With this fundamental misperception, economists believe that
it is possible to construct and implement a comprehensive economic plan—one
that will coordinate economic activities at least as well as and possibly
better than the market itself. (2) They can deny the existence of knowledge
unique to economists. With no unique knowledge of their own, economists
fail to see how policies that have systematic effects on the price system
can have systematic effects on the activities of market participants. Rational
expectations would enable the market participants to make corrections for
all such effects. But the possibility that market participants can form
such rational expectations is on a par with the possibility that central
planners can devise rational economic plans. And rejecting both possibilities
requires only that the significance of the Venn diagram be recognized.(5)

IV. Expectations in the Hayekian TheoryEach market participant pursues his individual interests on the basis
of the knowledge of his own circumstances coupled with the information
conveyed to him through the price system. If a monetary disturbance has
created systematic distortions in the price system, market participants
will be basing their choices and actions on misinformation, and the economy
will be characterized by discoordination. To be sure, expectations about
future movements or countermovements in prices come into play.(6)
Market participants will respond to a change in the rate of interest or
to a price change in different ways depending upon whether or not they
suspect that the change is attributable (in large part or in whole) to
some policy move on the part of the central bank. But in the context of
Hayek's theory, the claim that expectations will simply nullify the effects
that monetary policy would otherwise have had cannot be supported.
First, assume that some—but
not all—market participants know that credit expansion triggers an artificial
boom and that such an expansion is currently under way. They rationally
expect, then, that the boom will eventually end and that widespread economic
losses will be suffered. (Not even the economists can predict just when
the bust will occur and just who will suffer the losses.) Yet, for the
individual market participants (especially for the ones who understand
the economics of booms and busts), there are profits to be made by responding
to the distorted prices in near-conventional ways. The fact that production
processes are not characterized by complete vertical integration gives
scope for profiting from the early stages of production processes even
if each production process taken as a complete sequence of stages turns
out to be unprofitable. Resources can be profitably misallocated in response
to a distorted price so long as the resources are sold before the bust.
To argue that the expectation of an eventual bust would prevent the boom
from materializing is analogous to arguing that similar expectations with
regard to a chain letter would prevent the chain letter from being initiated.
Second, even if all market
participants understood the economics of booms and busts, they would have
no method of accurately correcting for money-induced distortions. Here
the analogy between the price system and a communications network—between
price signals and radio signals—can be pushed further: Knowing that a signal
is being jammed is not the same thing as knowing what the unjammed signal
is. During a monetary expansion the price of iron ore, for instance, may
rise by eight percent. This eight percent rise may consist of an increase
in the real price of iron ore (due to coincidental changes in the underlying
real factors) of two percent plus a money-induced price rise of six percent.
Or it may consist of some other combination of real and money-induced changes
whose algebraic sum is eight percent. Possibly the most plausible assumption
that market participants could make is that there have been no changes
in the underlying real factors since the beginning of the monetary expansion.
Economic activity based upon this assumption is analogous to a "dead reckoning"
on the basis of the most recent unjammed signal. After a protracted period
of monetary manipulation, the economy may well find itself considerably
off course. The ensuing readjustments would conform in the large—if not
in the small—to those that Hayek originally envisioned.
Third, the claim—based on
a weak form of the rational-expectations assumption—that there would be
no systematic undercompensation or overcompensation for money-induced distortions
across markets, even if true, is no basis for complacency. Resources are
allocated—or misallocated—on the basis of price differences, not price
averages. Resources would be allocated away from activities in which there
was an overcompensation for money-induced price changes and into activities
where there was an undercompensation.
Further, even if the market-clearing
price in a particular market reflects the "correct" amount of compensation
(such that the total volume of trade is unaffected by monetary manipulation)
there is still an element of discoordination. The market process imposes
a certain uniformity of price for a given good. Each market participant
pays the same price. But during monetary disturbances, each market participant
has a different idea about how changes in the price are divided between
real and money-induced changes. The market process imposes no uniformity
here. The absence of uniformity of perceived real price changes gets translated
by market participants acting on the basis of differing perceptions into
a discoordination of economic activity.(7)

V. Some Common ObjectionsThe range and variety of objections to the Hayekian theory of the trade
cycle reflect the richness and complexity of the theory itself. There are
objections found in the literature or heard in the classroom that call
into question each of the seven elements discussed in Section II. The following
discussion, however, looks beyond the theory's individual elements and
deals with questions based upon considerations of method and history:
1. Does Occam's Razor provide
a justification for rejecting the Austrian view in favor of some simpler
alternative?
2. What empirical evidence
is there to substantiate the Austrian theory?
3. Does the Hayekian theory
account for the length and depth of the Great Depression?
4. Can the depression be
wholly attributed instead to the fact that Federal Reserve ineptly allowed
a severe contraction of the money supply?

(1) The Question of ComplexityComplexity per se is not a virtue. No one prefers the Hayekian
theory over alternative theories because of its complexity. But
cyclical fluctuations are themselves complex, and any trade-cycle theory
that fails to recognize this fact is unlikely to contribute to our understanding
of them. Understanding the market forces that generate fluctuations requires
that we draw upon and integrate insights from price theory, monetary theory,
and capital theory. This integration is precisely what Hayek accomplished.
He built his theory on a solid microeconomic foundation; he identified
the effects of credit expansion on relative prices; and he drew on capital
theory to show why the boom was inherently unsustainable and why the bust
was characterized by an excess of higher-order capital goods and a shortage
of lower-order capital goods.
Occam's Razor allows us
to choose on the basis of simplicity between two alternative theories that
account for the same phenomena. For a given explanatory power, the
simpler the better. But Occam's Razor does not allow us to reject a complicated
theory that explains a complicated phenomenon in favor of a simple theory
that explains a simple phenomenon. The proposition, for instance, that
given wage and price rigidities, a monetary contraction will be accompanied
by unemployment is a relatively simple proposition—and a valid proposition,
as far as it goes. But it is simply not in competition with the Hayekian
theory of the trade cycle. It does not constitute an alternative explanation
of the intertemporal discoordination that characterizes business cycles.(8)

(2) The Question of Empirical ValidityAnother common objection is based upon the perceived lack or paucity
of empirical research that lends support to the Hayekian theory. Was there
a systematic misallocation within the market for capital goods during the
boom that preceded the Great Depression? Where is your data? This mode
of questioning is evidence of a misunderstanding of the relationship between
Hayekian theory and historical experience. Sharply stated, Hayek's theory
is not a theory in search of data. The question of why cyclical booms are
characterized by an overinvestment in fixed capital (the most conspicuous
form of higher-order capital goods) is a question that predates any theoretical
account—Austrian or otherwise—of this phenomenon. And historical accounts
of the economic developments during the 20's leave little doubt that this
boom was so characterized. Lionel Robbins (1934, p. 46), for instance,
charts the output of producers' goods and the output of consumers' goods
for the late 1920's. Using U.S. data he shows that the former rises with
respect to the latter in a way that squares with the Hayekian theory.
Charles Wainhouse (1984)
has recently employed the now-popular Granger-Sims technique to show that
movements in the interest rate, the volume of credit, and in the relative
prices of consumer goods and producer goods during the 1960s and 1970s
are consistent with the Hayekian theory. But while this study provides
an added increment of confidence in the theory, it is unlikely to constitute
a decisive margin. Those who question the applicability of Hayek's theory
to the episode of the Great Depression are unlikely to change their view
on the basis of these Granger-Sims tests.
The broader methodological
issues concerning the relationship between theory and history cannot be
addressed here at any length. The commonly encountered perception, articulated
at the Cato conference by the panel chairman, that "the Austrians believe
that facts are irrelevant" is, of course, a misperception. What the Austrians
reject is the present-day economists' adaptation of positivism in which
history, stripped of all nonquantifiable elements, unilaterally tests theory.
Following Mises (1969), modern Austrian economists recognize that theory
and history are complementary disciplines.

(3) The Question of Explanatory Power Still another common objection
is based upon the inability of the Hayekian theory to account for the extraordinary
depth and length of the Great Depression or to account for all economic
downturns (Haberler, 1976, p. 25; Yeager, 1986, p. 380), The theory is
being faulted, in effect, for not explaining more than it actually does
explain. It certainly cannot be argued that Hayek and his followers claimed
too much for the theory. Hayek's principal contribution to the development
of the Austrian theory was in the form of lectures at the University of
London in 1930-31—well before it was known just how deep (twenty-five percent
unemployment) and just how long (1929-1939) the depression would be. The
best-known accounts of the Great Depression from an Austrian point of view
are those by Lionel Robbins (1934) and Murray Rothbard (1975). Robbin's
book, originally published in 1934, deals with events up through 1933;
Rothbard's book, though originally published in 1963, traces the course
of events no further than 1932. Neither of these authors can be accused
of trying to push the Hayekian theory too far.
Nor is there any reason
to try to push the theory too far in this respect. Explanations for the
depression's extraordinary depth and length are not in short supply: There
was the severe monetary contraction that followed on the heels of the initial
downturn, the Smoot-Hawley tariff, and the many counterproductive programs
and policies of the Hoover and Roosevelt administrations—programs and policies
aimed at cartelizing industry, subsidizing loans to failing firms, destroying
agricultural output, and otherwise preventing wages and prices from adjusting
to the existing market conditions.
Hayek's theory demonstrates
that an economic boom fueled by credit expansion contains the seeds of
its own undoing. But to endorse this theory is not to deny that many of
the complications and exacerbations of the economic bust are to be attributed
to unique historical events.

(4) The Question of the Impact of Federal Reserve PolicyAnd finally, the Hayekian theory is rejected by some (Haberler, 1976,
p. 26 and Yeager 1986, p. 380) on the grounds that one of those unique
historical events, the severe monetary contraction, completely swamped
the effects of the intertemporal discoordination identified by Hayek. Economists,
it is argued, should focus attention on the contraction and its consequences.
This trivialization of Hayek's insights is puzzling for two reasons. First,
the monetary contraction was a unique historical event only in the sense
that it was not made inevitable by the preceding boom. The central bank
might have avoided the monetary contraction, in which case economic recovery—intertemporal
recoordination—would have been achieved much more quickly. But surely,
it was the disruption in economic activity associated with the discoordination
in capital markets that set the stage for Federal Reserve's mismanagement
of the money supply.
Second, it is not clear
why we should expect economists to direct our attention to the most salient
features of the Great Depression. Economic difficulties and hardships whose
proximate cause was the collapse of the banking system can be seen by historians
and even by journalists. We do not expect a meteorologist to direct our
attention to the six feet of snow lying on the ground. The crystalization
in the upper atmosphere that preceded the storm is his proper concern.
Accordingly, the economists' proper concern is with those characteristics
of the boom that can precipitate a bust. Hayek's theory has a claim on
our attention that is not diminished by the events, however dramatic, that
were subsequent to the initial downturn.

VI. A Summary AssessmentThe Hayekian theory of the trade cycle offers insights into the workings
of the economy that are as valuable today as they were a half century ago.
But prospects for widespread acceptance of the Austrian view remain dim.
Nor is the theory likely to be used as a basis for policy prescription.
As in so many other instances where policy makers confront economic issues,
considerations of political expediency and of economic soundness cut in
opposite directions. The short-run political gains associated with an artificial
boom take precedence over the long-run stability associated with monetary
responsibility.
But the Hayekian theory
of the trade cycle is also unlikely to be wholly forgotten. Those who are
willing to discover just what the theory is, how all its elements fit together,
and what it can—and cannot—explain will find their efforts rewarded. They
will have a understanding of the market mechanisms that can achieve an
intertemporal coordination of economic activities and of the consequences
of interfering with those mechanisms.

________. "Intertemporal Price Equilibrium and Movements
in the Value of Money," (originally published in German in 1928), in F.
A. Hayek. Money, Capital, and Fluctuations: Early Essays. pp. 71-117.
Edited by Roy McCloughry. Chicago: University of Chicago Press, 1984.

Keynes, John M. The General Theory of Employment, Interest,
and Money. New York: Harcourt, Brace, and Company, Inc., 1936.

Lachmann, Ludwig M. "The Role of Expectations in Economics,"
(originally published in 1943) in Capital, Expectations, and the Market
Process. pp. 65-80. By Ludwig M. Lachmann. Kansas City, MO: Sheed,
Andrews, and Mc,Meel, Inc., 1977.

*The post-conference draft of this paper was prepared
with the benefit of critical assessments by Gerald P. O'Driscoll, Jr.,
Murray N. Rothbard, and Leland B. Yeager as well as by the formal discussant,
Michael D. Bordo. Helpful comments from Donald J. Boudreaux and Roger Koppl
are also gratefully acknowledged.

1. The title phrase "Hayekian trade
cycle theory" was suggested by the editor of the Cato Journal. Murray
Rothbard has reminded me that in its heyday it was known as the Mises-Hayek
theory of the business cycle. There is no dispute in the present paper
over names and credits. The more broadly conceived "Austrian theory of
the business cycle" would serve just as well.

2. In the Austrian literature, the
difference between a nominal price and a real price involves more than
a simple adjustment for expected changes in the price level. Important
differences are attributable to "injection effects," which vary across
goods and exist independent of any actual or expected change in the general
level of prices. The relevant contrast is between actual money prices and
prices that are consistent with the underlying real factors.

3. Note that this bidding up of the
rate of interest at the end of the boom is quite independent of any rise
in the general level of prices. That is, the Ricardo effect is distinct
from the more-widely-recognized Fisher effect.

4. The relative size of the intersection,
the area common to both circles, is determined endogenously—by the interaction
between economics and politics. No doubt, the size of the common area is
positively related to the extent of government intervention: With increasing
intervention, market participants find it more worth their while to learn
how the market process works and how it is affected by government policy;
and economists cum policy makers find it increasingly necessary
to understand the particulars of the markets that are being affected by
government interventions.

5. Thus, the Venn diagram helps to
reconcile the fact that the rational-expectations approach to understanding
business cycles has important Hayekian roots (see, e.g. Lucas, 1981, pp.
215) with the realization that the New Classicists' vision of how the market
process works and how policy can affect it is fundamentally at odds with
Hayek's own vision. The New Classicism incorporates the Hayekian insight
that the price system facilitates the use of knowledge in society but fails
to maintain the distinction between the two kinds of knowledge identified
by Hayek. For a complementary view of the relationship between Lucas and
Hayek, see Butos (1985).

6. See Hayek, 1975c, for an early recognition
of the importance of expectations in trade cycle theory.

7. This aspect of money-induced discoordination
as it relates directly to the rate of interest is clearly recognized by
Leijonhufvud (1984, pp. 31f.) The market imposes a uniformity on the nominal
rate of interest but not on the way in which that nominal interest rate
is divided, in the minds of individual market participants, between the
real rate and the inflation premium. My own formulation consists of a simple
extension of this important insight from the interest rate itself to the
interest-dependent prices of capital goods.

8. Strictly speaking, to qualify as
a theory of cyclical fluctuations, the theory must account for at
least one endogenous turning point. It must show, for instance, how an
artificial boom contains the seeds of its own undoing. We can compare on
a one-to-one basis the self-reversing processes identified by Hayek and
by Friedman. One focuses on the market for capital goods and spells out
the cyclical process in terms of Hayekian triangles; the other focuses
on the market for labor and spells out the cyclical process in terms of
short-run and long-run Phillips curves. But an account of monetary disequilibrium—even
of snowballing monetary disequilibrium--that is triggered by an exogenous
contraction of the money supply does not constitute a theory of cyclical
fluctuations.